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In Search of: Alternatives

Remember the old TV series hosted by Leonard Nimoy In Search of...?  The show educated and attempted to explain plausible theories behind mysteries ranging from Atlantis to Amelia Earhart's disappearance.  Let's take a journey and explore Alternative Investments and how they may belong in a well-managed, diversified portfolio - if at all. Using software written by AdvisoryWorld Financial Technology, I've been modelling my portfolios and trying to determine if there are better combinations of asset classes that may provide a better risk/return portfolio than a diversified 60-40 with Fama/French tilts. My benchmarks for comparison for the period 9/15/05 to 7/31/11 are:

PortfolioReturnStandard DeviationSharpe Ratio
60% S&P/ 40% Barclay's Agg3.97%9.22%0.21
Diversified 60-405.57%11.7%0.30

For those that aren't familiar with the Sharpe Ratio, it tells us what kind of bang we're getting based on the risk we're taking.  The higher the ratio, the better the risk/return tradeoff. 

Therefore, although the Diversified portfolio has a higher StD than the generic index portfolio, the return goes up incrementally more per unit of risk, so it is a better risk/return portfolio. I tried adding some alternative investments to the mix which include the Lipper Equity Market Neutral index, the Lipper Long/Short Equity index, and managed futures (represented by RYMTX)*  The results are:

PortfolioReturnStandard DeviationSharpe Ratio
With Market Neutral4.50%9.36%0.26
With Long/Short4.29%10.22%0.22
With Managed Futures4.41%8.79%0.27

As you can see from the table, the managed futures had the biggest effect on lowering volatility with the least impact on Sharpe Ratio.  However, the Sharpe is lower than the original portfolio.  But - the StD did go down.  So, I had to ask myself, if I decreased the equity exposure in the diversified portfolio to lower StD, how would that compare to the 60-40?  The results:

PortfolioReturnStandard DeviationSharpe Ratio
Diversified 50-505.67%9.86%0.37

Based on this final portfolio, I think that the anomalous event of 2008 is overshadowing the real effects of what would be a good long-term comparison.  Because alternative asset classes are so new and the 2005 inception date of the Core Equity portfolios is somewhat recent (as of this posting), we should not draw any long-term conclusions.  But for the time frame in-question, I've concluded that none of these alternatives offered a benefit to the investor.  As well, these strategies are very expensive and tax-inefficient.  Therefore, I cannot conclude that the addition of these alternative strategies will produce a positive affect in a portfolio over a longer time period, and am inclined to believe the opposite. If you have an advisor that is encouraging you to move some money into any of these investments, get answers to these questions:

  • What is the correlation of this investment to my current strategy?
  • How do you expect this to improve the Sharpe Ratio of my current portfolio?
  • Will this new investment have an adverse effect on my taxes?
  • Why did you choose (managed futures/long-short strategy/market neutral) instead of (the other two)?

And if you really do ask these questions and get answers - PLEASE share them in the comments! *RYMTX was used as a proxy because it has the longest time horizon of this very new asset class but is still limited to an inception date of 3/2/07.